We’ve been skeptical of inflation targeting, no doubt as a result of seeing Paul Volcker use monetary targets very effectively. Witness the proof of the pudding, namely, asset bubbles, deteriorating credit quality, and increasing inflation (at least in overall CPI, although core CPI is better behaved). But serious economists have only started looking into this issue (although the European central banks have recently taken more interest in monetary aggregates as well as inflation targets).

This post by Axel Leijonhufvud at VoxEU, in an elegant and accessible discussion, shows that economists are finally grappling with something (IMHO) they should have addressed years ago, namely the influence of all the forms of private sector near money, such as credit cards, debit cards, and other payment (which the paper refers to as “inside money’) on money supply and growth. (Admittedly this might not be the province of mainstream academic research, but Greenspan had the Fed’s bright young economists, a very valuable resource, worrying about stock price levels rather than understanding money!) Other economists, such as Harvard Management’s Mohamed El-Erian, have written in a more general fashion about private sector liquidity creation.

For an academic economist, Leijonhufvud is blunt. He makes it clear that current conditions cannot persist. “At some stage, central banks will have to mop it [liquidity] up or see inflation do it for them.” And we can’t be certain how bad things will get, in part because the authorities do not know where the risks are buried, and in part because the actions of the participants will influence how things unfold.

From VoxEU:

An expansionary monetary policy and an historical conjuncture that happens to produce no inflation will lead to asset price inflation and deterioration of credit. At some stage, central banks will have to mop the liquidity or see inflation do it for them.

To control the price level, Patinkin demonstrated many years ago, you need control of one interest rate and one nominal asset for which the private sector cannot produce a close substitute. Although the theory did not say so, in practice it was obvious that this nominal stock had better not be very small. Just the copper coinage would not do, for instance. Thus Monetarism relied on 1) control of the base, 2) the stability of the base-multiplier which was ensured by reserve requirements on banks, and 3) the only very slowly changing habits of the public with respect to the use of paper currency.

Monetary policy, in this context, was thought of as operating on the determinants of the equilibrium price level to which the actual level would adjust, albeit with “long and variable lags.”

All that is long gone, of course. Reserve requirements are no longer enforced, the private sector is busy producing ever more substitutes for the use of currency — and the base is now demand-determined. We are now in a Wicksellian world of pure inside money in which no determinate equilibrium for the price level exists. Monetary policy then becomes the art of using the federal funds rate to control the rate of change of the price level. Ideally, the Central Bank should hit Wicksell’s “natural rate” on the nose so that the price level would stay constant. But it does not know what that rate is. It has to behave adaptively, therefore, watching the inflation rate and countering any movements in it by moving the interest rate in the opposite direction.

This is a High Wire Act! The long and variable lags are presumably still with us. The feedback, when it arrives, is not always unambiguous. What prices belong in “core inflation” if the CPI does not provide the best signal?

If this is so hard in theory, why does it seem to be so easy in practice? Interest-targeting is widely regarded as an almost unqualified success. But consider American monetary policy. Does the absence of inflation since the turn of the century show that the Fed has smartly kept the interest rate in the near neighbourhood of the “natural rate”? Obviously not. More than a dozen quarter-point hikes of the short rate to which the markets paid basically no attention (the long rate not reacting) mean instead that the Bank had engaged in such an extraordinarily expansionary policy that it had lost all contact with the markets.

If the Fed was flooding the world with dollar-denominated liquidity, why was there no significant inflation? Part of the answer is that in the early-going, the Fed was fighting deflation in the wake of the ITC bust. But the more significant part of the answer lies in the determination of other central banks to prevent their currencies from appreciating against the dollar. With their exchange rates more or less fixed, the elasticity of their exports has kept American inflation in check. This short-circuits the feedback loop on which an adaptive inflation-targeting policy relies. The behaviour of the price level provided no clue to the Fed that its policy was far too expansionary.

If you run a very expansionary monetary policy and the historical conjuncture happens to be such that you get no inflation, what do you get? The answer, of course, is asset price inflation and deterioration of credit. This is the troubling legacy of policy that we are now left with.

How dangerous is it? Judgements vary and they do so because no unconditional answer is possible. What dangers will actually materialise depends on how the current financial imbalances will eventually unravel, on where inflationary pressures will first become serious, and on how the policy-makers of the major countries will respond to unfolding events. Some plausible scenarios are more reassuring than others.

The sanguine view is that securitisation and credit derivatives have made the world of finance a safer place than it used to be and that, besides, liquidity is ample all around. But it is not likely that the world will stay awash in liquidity forever. At some stage, central banks will have to mop it up or see inflation do it for them. Securitisation and credit derivatives have certainly dispersed risk through the economy and away from the banks where it used to be concentrated. But by the same token, the system has taken on more risk and we know less about where large concentrations of risk-bearing may be located. Risk spreads have narrowed in part permanently because of these new risk-sharing technologies, but in part transitorily because of the extraordinary level of liquidity. Narrow spreads have in turn induced some institutions to assume high leverage in search of yield.

A number of very large failures – LTCM, Enron, Amaranth – have occurred causing nary a macroeconomic ripple, and this is frequently cited as proof of the resilience that recent financial innovations have imparted to the system. It may be, however, that the more appropriate conclusion to draw is that macroeconomic developments are more likely to trigger trouble in financial markets than vice versa.

2 comments

I’m flattered that you think I have insight into this question. It’s pretty fundamental and hotly debated these days.

If one were to try to simplify this story, it is that there has been way too much lending on generous terms to dubious propositions: subprime mortgages, private equity, hedge funds, commercial real estate (lending has become overheated even there), and emerging markets.

Mind you, none of these are bad borrowers per se if creditors make sure they verify that the borrower is pretty likely to make timely payment of interest and principal, and have charged enough to allow for the possibility he might go belly up. But that discipline has gone out the window.